The Inflation Riddle

The inflation debate over the last several years, especially in the aftermath of Covid, has been marred by major misperceptions which led to consistent false inflation predictions and badly timed policy decisions. Years of benign inflation made both policy makers and market analysts believe that any spike in inflation was likely to be subdued and transitory. The disruption in the supply chain following Covid gave them the narrative to support such beliefs, which were further amplified by the war in the Ukraine. Thus, the common theme was that inflation will be either transitory or cyclical at worse. Caught in their complacency, central banks and most market observers failed to recognize that there was a major shift in global economic trends. In particular, the era of globalization and its benefits of better efficiency and declining prices started to show cracks even before Covid. By its nature, deglobalization represented a structural rather than a cyclical shift and, thus, will most likely manifest itself in a prolonged period of elevated prices. While disruptions in the supply chain and dislocations in the job markets amplified the inflationary effect of deglobalization, rising global political and trade tensions and their manifestation in trade sanctions and other barriers to free trade are likely to make the inflationary forces of deglobalization more permanent. These forces are further enhanced by the trend to bring production facilities back home.

Within the environment of deglobalization, several additional factors pointed to a prolonged period of elevated inflation. While markets have focused on the contractionary effect of central banks’ rising interest rates policies, they failed to recognize that fiscal policies remain expansionary. Not only has the excess liquidity that was poured into the global economy remained in the system and continued to fuel growth, but also fiscal deficits remain at elevated levels and serve to counter-balance central banks’ contractionary policies. Thus, after long periods in which monetary and fiscal policies worked in tandem to promote growth, we are now facing a period in which they work in opposite direction, thus negating or limiting their respective effects. The fiscal deficit situation suffers from the fact that there are no political gatekeepers on the fiscal side and each ruling party, at its turn, uses expansionary spending to serve its political agenda. Furthermore, the dislocations following Covid and the war in the Ukraine gave governments justification to prolong such expansionary policies beyond what was needed, thus further contributing to the dislocations. By its nature, deglobalization and the attempt to bring critical industries back home with subsidies will further contribute to the fiscal deficits. Deglobalization will also lead to capital investments by the corporate sector which will also negate some of the monetary policy effects. Since not all policy measures serve to slow growth/fight inflation, the period of elevated inflation levels will most likely be longer.

Markets focused on the pace at which the Fed has raised rates and extrapolated that it will lead to recession, which will help to tame price levels. Yet, they failed to recognize that the rapid pace was due to the Fed’s misjudgment of the situation and we are still far from positive real interest rates. By their nature, negative real interest rates tend to support rather than curtail growth. As long as growth gets the tailwinds of negative real interest rates and expansionary fiscal policies, we are not likely to see the moderate recession that is necessary to bring inflation back to its comfortable levels.

All of the above arguments make us believe that the era of elevated inflation is structural by nature and, thus, likely to be with us for an extended time and at levels which we have not seen for decades. Any belief that it can be solved by quick policy measures is misplaced and likely to be proven wrong.